SPEECH/02/172

Pedro Solbes

Member of the European Commission responsible for Economic and Monetary Affairs

Economic governance in the EU: towards closer economic policy coordination

European Institute luncheon, Dumbarton Room, Four Seasons Hotel

Washington, 19 April 2002

Ladies and Gentlemen,

Let me start by thanking the organisers for giving me the opportunity to share with you my views on Economic Governance in the EU.

The issue of Economic Governance is especially topical since the introduction of the euro notes and coins more than three months ago has completed in a sense the monetary integration. Moreover, the upcoming enlargement of the EU requires a smoothly functioning co-ordination framework. The costs of inadequate co-ordination and procedures may rise more than proportionally with the number of Member States.

The way forward for EU economic governance will also strongly be affected by the outcome of the European Convention. The Convention contemplates on the future of the whole European Union project. It looks at the balance of powers and responsibilities between Member States and the Community, and on the shaping of its Institutions accordingly. This will not leave Economic Governance unaffected.

My intervention today will be divided into two parts.

• I will first briefly address the concept of policy co-ordination and the need for strengthening policy co-ordination in the euro area and the EU.

• Thereafter, I will present the main elements in the EU's broad framework for economic co-ordination and discuss the challenges and flag some of the key issues on which we are currently working to improve the effectiveness of co-ordination.

  The concept of economic policy co-ordination (in EMU)

Let me start by clarifying the concept of co-ordination. The term "policy co-ordination" is being used for a variety of cases. Fiscal policies can be co-ordinated amongst Member States to avoid negative externalities. Coordination of monetary and fiscal policies at the euro-area level may facilitate obtaining a policy mix that is well geared to the prevailing economic situation. Finally, consistent and mutually enhancing macro- and microeconomic policies will be conducive to the overall economic performance.

Reflecting this variety, in the EU co-ordination is used as an umbrella term. It encompasses an entire spectrum of interactions among policy actors. The range of methods applied includes information exchange, discussion of best practices, policy dialogue, commonly agreed policy rules and objectives, peer review and, when necessary, jointly determined actions.

Coordination within the fiscal policy sphere is based on clear rules, backed up by a sanction mechanism if necessary. In the case of interactions between fiscal and monetary authorities, the methods most used are information exchange and dialogue. And as regards microeconomic policies and the structural reform process, the main instruments are analysis and monitoring to detect best practice, and peer pressure to speed up implementation.

Accordingly, policy competition -- by which I mean the test in economic reality of policies and structures in different Member States as to their capacity to enhance the economic performance -- and policy co-ordination are not mutually exclusive. In fact, policy competition can be seen as an element in the broad spectre of economic policy co-ordination. In weak forms of co-ordination, policy competition plays an important role.

It can be argued that an important element of European economic integration, a single market with a single currency, includes and fosters competition between systems (e.g. fiscal regimes) and between structures (e.g. labour market institutions). This competition should lead to "best practices" effects for policies.

Why does co-ordination need to be strengthened in the EU?

The key economic motivation for co-ordination is to take account of spill-overs of national policies. It enables internalisation of these spill-overs in policy making and therefore a better allocation of resources and higher potential growth. The more likely and significant cross-border spill-overs of national policy are, the more reason there is for a comprehensive coordination framework. The importance of the spill-overs is strongly related to the extent of economic integration. On the other hand, co-ordination involves costs. Moreover, there is a need to preserve democratic legitimacy, to respect differing national preferences and the concept of subsidiarity.

The process of economic integration in the EU has moved into higher gear since the late 1980s. The drive to complete the Single Market by 1992 and the ongoing work by Member States to complete transposition of relevant Directives into national law has strengthened and is still strengthening trade links between the Member States. The creation of EMU in 1999 has taken economic interdependence a step further. It has resulted in a unique institutional framework. A single monetary policy is entrusted to an independent, supranational central bank. However, decentralised economic policies remain in the hands of national actors.

Today, a policy line taken unilaterally by one country may impact the economic conditions of the others much more than in the past. A national policy action that affects, for example, the average inflation rate will in turn determine the ECB's decision on interest rates. This way the national policies affect all other EMU Member States. Strengthened co-ordination is needed to take account of these effects in national policies and particularly so within the euro area.

However, economic integration and policy spill-overs are not limited to the euro area. The whole of the EU is in a continuous process of increasing economic integration. Whereas in some areas additional coordination may be needed within the euro area, in general the whole EU is involved in strengthening economic governance.

Key elements of the existing co-ordination framework and main challenges

To coordinate the policies that remain within national competence, a rather complex and elaborate system has been put in place. The appreciable complexity of the system is mainly due to the gradual approach by which the co-ordination framework is being developed. New procedures are added when deficiencies are exposed in experiences with prevailing procedures.

The drawback of this high complexity is that very few specialists know and understand the procedures. There is scope to streamline and simplify the procedures. And coherence between the policy recommendations of the various procedures should become a key priority. Otherwise we risk that a multiplicity of incongruent voices confuses the public, endangering the credibility and effectiveness of the whole co-ordination framework.

The European Council has repeatedly confirmed that the Broad Economic Policy Guidelines (BEPGs) are at the centre of economic policy coordination and give coherence to the framework. They contain orientations for the general conduct of economic policy and make specific recommendations to each Member State and to the Community.

The BEPGs' general policy orientations are developed further by more specialised procedures, which need to be consistent with the former. Among these, the Stability and Growth Pact deals with budgetary policy; the European Employment guidelines with labour market policy; the Cardiff process with product and capital market reforms; and the Cologne process formalises the macro-economic dialogue.

I will now discuss some key areas of the policy coordination framework by briefly sketching the principal elements and the main challenges. First I'll discuss fiscal policy co-ordination, then touch briefly on the dialogue between fiscal and monetary authorities, and finally turn to the co-ordination of structural policies.

Fiscal coordination

The serious risk imposed by fiscal imbalances to euro-area wide stability and the obvious effect of national fiscal policies on the common interest rate makes the need for close coordination of macroeconomic policies, notably budgetary policies, undisputed. This has been reflected in the strong rules-based co-ordination in the Treaty and the Stability and Growth Pact.

To address the most obvious threats to macro-economic stability stemming from the budgetary side, the freedom of national budgetary policies is constrained. Hence, excessive deficits of more than 3% of GDP are expressly forbidden.

Moreover, the SGP requires Member States to attain budgetary positions of "close to balance or in surplus" over the cycle. This is not only to ensure sound public finances in the long run. It also creates room for the automatic stabilisers to cushion economic fluctuations.

Once the Member States have completed the transition phase to a medium term budgetary position of 'close to balance or in surplus', it enables (together with the flexible monetary policy) a smooth adjustment of the policy mix to changing economic circumstances. In profound recessions, the leeway for stabilisation may be insufficient. In that case however, the Treaty provides an escape clause that allows budget deficits to temporarily overshoot the 3% of GDP ceiling.

Still, there is a widespread tendency to associate fiscal discipline with a « straightjacket ». I do not share this view. In my opinion, it is a highly effective system that ensures sound fiscal behaviour, predictability and a fair amount of flexibility to cope with adverse cyclical developments. It should be clear that the Stability and Growth Pact is not an arbitrary legal constraint on fiscal policy. On the contrary, it is the operational application of general principles of sound fiscal behaviour.

Balanced budgets will allow to make speedier progress in reducing public debt as a percentage of GDP. In turn, this reduces the debt service burden and helps improving the structure of government budgets which is imperative in view of the consequences of the ageing of European populations and in an institutional setting with pension systems that are generally not funded, i.e. no capital has been accumulated to cover future pension liabilities.

In the field of fiscal policy coordination, in general the framework has functioned successfully. Admittedly, some problems have surfaced in a few Member States, but they stemmed from incomplete progress towards sound budgetary positions. This lengthened the transition to cruising speed or the steady state. In addition, we have always stressed that coordination is a learning-by-doing endeavour. Hence, the procedures are gradually streamlined and strengthened.

The surveillance process of the Pact has recently been improved with the adoption of a new 'Code of Conduct on the content and format of stability and convergence programmes'. It streamlined the procedure and extended its coverage to include the long-term sustainability of public finances. This is important in view of the budgetary consequences of ageing. Increased focus will also be given to the analysis of cyclically-adjusted budgets rather than nominal targets alone.

Currently, we and the Member States are working on a number of improvements to further enhance the framework and the analytical input for coordination at large:

• First, we are working on improving the statistical and analytical basis for the euro area, which is key for a common and robust assessment of the economic situation.

  Much progress has been made in improving euro-area statistics, but there are still insufficient activity indicators that provide a synthetic view of the euro area. We are fostering efforts to remedy these shortcomings.

  A close and frequent evaluation of the euro-area's monetary-fiscal policy-mix is fundamental for analytical purposes. We have started to present to the Member States an assessment of the overall policy mix. We do so before and after the presentation of the stability and convergence programmes, in order to improve their preparation and evaluation.

• Second, it is generally agreed that Member States could benefit from internal budget rules to better control the growth in budget expenditures and enhance the responsibilities of different levels of government. Spending rules would improve the budgetary discipline by allowing a closer targeting of structural balances. At the same time they would allow the automatic stabilisers to play, as its largest impact stems from the revenue side. We encourage Member States to proceed on this road where necessary.

• Third, the coherence and predictability of the coordination framework would benefit if actors behaved according to some general rules for the conduct of economic policies. These rules should lay down the principles on which policy instruments react to cyclical conditions or shocks.

  Shortly, we will present a set of practical standards for the conduct of economic policies in the EU, and we hope to reach consensus with the Member States.

  Dialogue between fiscal and monetary authorities

A stable macroeconomic framework reduces uncertainty and risk premia, improves the allocation process and strengthens potential output. In this context, the best contribution monetary policy can make to sustained growth and employment creation is to secure price stability over the medium term. For this reason, the primary objective assigned to the ECB is to maintain price stability and the Eurosystem has been granted independence from outside instructions in the pursuit of its tasks.

But obviously the ECB does not operate in a vacuum. The economic governance system set up with the Maastricht Treaty foresees several channels for contacts and dialogue of policy actors in various institutions. Just to give one example, I myself attend frequently meetings of the Governing Council of the ECB, without however being entitled to vote.

Moreover, with the setting up of the Eurogroup, a gathering of Ministers of Finance, Commission and ECB, an additional informal forum has been put in place to ensure that Member States' budgetary authorities and the ECB remain in close contact with each other and are in a position to exchange information on each other's analysis of the economic situation and ensuing policy requirements.

Overall, this framework has worked well. The macroeconomic policy mix in EMU has been well geared to the economic situation. In the recent slowdown, for instance, monetary authorities judiciously used the leeway provided by declining risks to price stability over the medium term while budgetary authorities let automatic stabilisers work within the agreed rules.

Participants in Eurogroup meetings have highly valued the frank and free discussions in the informal gatherings. Several organisational improvements have been made since the group was set up. On substance, the most noteworthy change has been the extension of the range of topics dealt with. Now also structural issues are being discussed.

Structural policy coordination

This brings me to my last point, the coordination of structural policies. Often, the rationale for coordination of structural reform is not well perceived. But there can be no doubt that effective structural reforms are essential in enhancing the overall economic performance of the EU.

Economic reforms improve the allocation of resources, allow to increase labour supply, facilitate technological advances and encourage investment growth. In short, the reform process boosts potential output growth. This is what we need, because potential output in Europe is still insufficient to sustain actual growth rates of around 3 % over an extended period whilst we aspire to such a performance, in line with the objectives agreed by the Lisbon European Council.

Moreover, there are also strong arguments for making headway with the reform process from a macroeconomic policies' perspective. Firstly, flexible markets are essential for the well functioning of EMU, where national nominal interest and exchange rates are no longer available to help cyclical and structural adjustments. Secondly, a failure to boost the growth potential through reforms renders more difficult the sustained consolidation of public finances. And finally, broadly based progress with reforms that decreases inflationary pressures for the euro area as a whole facilitates a positive response from monetary policy.

Similar to the fiscal sphere, Community actions in the field of structural reforms chiefly concern the coordination of policies that remain in the hands of Member States. When the structural reforms have a direct relation to the Internal Market, however, they are subject to either Community wide policy (e.g. competition policy) or a common set of rules (e.g. the Single Market Programme).

Contrary to the assessment of fiscal policy, where the Stability and Growth Pact ultimately foresees sanctions in the case of non-compliance, there is no Community mechanism for ensuring the enforcement of reforms in Member States. Structural policy co-ordination relies on the exchange of best practices and on peer pressure.

Given this lack of enforcement mechanisms, it is not surprising that Member States focus their progress, to a large extent, on more uncontroversial measures while leaving the more difficult ones sometimes untackled. As a result, despite an elaborated policy coordination framework, progress in structural reforms in some areas still fails to match our ambitions.

Nevertheless, I think we should not underrate the process that has been set in motion. Back in May '98, when the decision was made which Member States would begin with EMU, ECOFIN ministers stressed the importance of market flexibility from an EMU perspective. In Cardiff the same year, the heads of state or government endorsed this and the Cardiff process of economic reform was born. Lisbon strengthened the commitment to economic dynamism and most recently in Barcelona further steps were made in liberalising markets. Sometimes, the individual steps may be small. But the process has gathered momentum, and all this would not have been achieved without the discussions at Community level and the peer pressure building on that basis.

The Commission is doing its share by clarifying its policy proposals and making them more visible. It is important to communicate widely and effectively the macroeconomic benefits of structural reform, and it should be clear that the costs of non-reform are high in terms of employment and growth.

Concluding remarks

In my speech, I tried to indicate that the foundations of the EU framework for the conduct of economic and monetary policies are anchored in our Treaty and in secondary legislation. These foundations include a clear allocation of policy responsibilities, a set of shared objectives, common rules for the conduct of policies and an institutional set-up with adequate policy instruments.

Our framework is based on modern economic thinking. It has functioned well during the early years of EMU. The euro has been a success, notably in delivering low inflation, low long-term interest rates, and strongly improved budgetary positions all of which allowed strong job creation.

In general, economic and monetary policies have responded flexibly to changing economic conditions in the short run, whilst stimulating strong employment growth and improvements in the economy's productive capacity in the medium term and safeguarding long-run sustainability.

To ensure the success of EMU in the future, the way forward is definitely to build upon and further strengthen our framework. This will be part of the comprehensive exam of the future of the EU that will be made in the Convention that has just been convened.